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Summary

  • If you want the "hot porridge" bank stocks that offer significant potential for capital appreciation and dividend growth, look to Citigroup and Bank of America.
  • If you want to purchase the banks situated in the middle, look to JPMorgan and Wells Fargo.
  • And on the "cold" end of the growth spectrum is M&T Bank, which offers great stability but little likelihood of significant capital appreciation and substantial dividend growth.

When Goldilocks entered the house of the three bears, she had to face three bowls of porridge: one was too hot, one was too cold, and one was just right in the middle. For investors mapping out the dividend growth and capital appreciation projections of large-cap US banks, they may find themselves in a similar situation: some of the bank stocks may be hot in that they offer the potential for significant capital appreciation and dividend growth, some are in the middle in that they offer meaningful share price appreciation and dividend growth, and others are on the low end when it comes to offering future capital appreciation and dividend growth.

First, let's take a look at the two companies that fall into the "high share price appreciation potential/high dividend growth potential" category: Citigroup (NYSE:C) and Bank of America (NYSE:BAC).

Citigroup is a fascinating company to study for the investor that has a truly long-term orientation, and is focused on share price appreciation and dividend payouts ten years from now. What makes Citigroup so intriguing is that the company is trading at a discount to book value and seems to have significant earnings power to support future dividend growth.

Specifically, Citigroup is currently trading at a valuation of $47.60 even though its book value per share is currently $65.23. This is about one of the only large-cap companies in the world trading within hailing distance of Benjamin Graham territory. Graham would insist on a two-thirds discount to intrinsic value, and you would fully meet Graham's margin of safety requirements if you purchased the stock below $43.70, but any way you slice it, the stock is trading at a meaningful discount to what would constitute its fair value.

The implications for Citigroup's long-term ability to pay a significant dividend are favorable as well. In 2013, Citigroup earned $4.39 per share. Assuming a long-term dividend payout ratio of 35%, Citigroup would have the present capacity to pay shareholders $1.53 in dividends based on the profits it has earned over the past year. The power to pay dividends is there (from the headlines associated with Citigroup, you'd have no idea the bank made $13.9 billion in net profits last year), but the stock would be most appropriate for those investors that can stomach the extended wait that may be necessary as Citigroup returns to dividend normalcy.

The next company in the category is Bank of America, which is also trading at a substantial discount to book value. At a current price of $15.44, Bank of America's current valuation is well south of last year's book value of $20.71 per share. Someone applying Graham's methodology and insisting upon a one-third discount to book value wouldn't hit the buy button until the price fell to $13.87, but the current price of $15.44 still incorporates a significant margin of safety.

Like Citigroup, Bank of America's dividend has also had trouble getting off the ground, although the potential for future dividend growth for investors with a truly long-term investing horizon remains sound. Given that Bank of America is generating $1.20 in normalized profit when you exclude litigation costs, a patient investor that is willing to hold the stock for the next few years ought to be able to see an annual dividend of at least $0.36 based on current profits, assuming a 30% dividend payout ratio.

Then, there are the banks in the middle: JPMorgan (NYSE:JPM) and Wells Fargo (NYSE:WFC).

Both of these banks offer greater margins of safety in terms of current business performance, but they offer less of a margin of safety in terms of stock price due to the fact that they are much, much further along in their financial recovery development and thus the stock price reflects that fact.

In the case of JPMorgan, the company is trading at a slight premium to its book value (the book value of $53.25 per share indicates that the current price in the $57-$58 range puts the price of the stock at a 7-10% increase over its book value). Wells Fargo, meanwhile, has no pretense of being on sale at $52 per share: its book value of $28.65 means the stock is only another $5 advance in stock price away from trading at double its book value. The reason why Wells Fargo trades at such a premium is that many investors believe that its reported book value figures reflect a higher quality, which you can see by the fact that Wells Fargo only reported 0.41% in total net charge-offs from its $1.52 trillion total-asset portfolio.

The reason why I put these two stocks in the "middle" category is not only because they don't have the same discounts as Citigroup and Bank of America, but because they don't have the same room to increase their dividend payout ratio as Citigroup and Bank of America.

At JPMorgan, the company is paying out 35% of its profits to shareholders as dividends. In the case of Wells Fargo, the company's payout ratio is essentially the same, as it is returning 36% of its cash profits to shareholders in the form of dividends. They still have some room to run, as their long-term dividend payout ratios could hover near the half-of-profits mark (so it is possible that dividends could grow faster than earnings for the next 5-10 years), but generally speaking, shareholders will eventually be relying on the earnings per share growth to fuel dividend growth over the long term.

And then, in the last category, you have M&T Bank (NYSE:MTB), which neither offers a discount to book value nor does there seem to be a track to dividend growth. At a current price of $124 per share, the price of the stock has gotten well ahead of its book value of $79.87 per share (as the stock trades at a premium of over 1.5x book value).

Why the lofty valuation for M&T? Because the bank performed brilliantly throughout the financial crisis. When M&T increased its 2007 dividend of $2.60 to $2.80 in 2008, it subsequently held its dividend steady throughout the duration of the financial crisis (making it one of the few large American banks that never had to cut payouts to shareholders). Even at the low point in 2009, M&T was one of the few large banks still generating enough cash to cover its dividend, as the dividend payout ratio hit a high of 94% in 2009 before snapping back quickly to 51% in 2010.

Even though the safety of M&T's dividend is not in question, the concern about M&T is that it is too richly valued and growing too slowly to justify a fresh investment at this price. The bank has only grown profits at 4% annually these past five years, and the dividend is still frozen at $2.80. With M&T Bank, you receive the quality, but not the growth.

To figure out the right answer for how you should approach bank investing, you must first determine your goals. Do you want significant capital appreciation and dividend growth while taking on some risk? If so, look to Citigroup and Bank of America. Do you want a balanced attack of dividend growth and safety? Then look to JPMorgan and Wells Fargo. If you want a proven track record of stability and dividend maintenance during crises, and are less focused on growth, then M&T Bank makes a lot of sense. It's about tying your personal goals and styles to the particular profiles of these different banks.

Source: The Goldilocks Approach To Bank Stock Dividends